Searching for Buried Treasure in the Financial Markets using a Value Investing Approach

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Is the U.S. Stock Market Currently in a Bubble? (Part 2)

Expanding on my previous post, let’s look at a few other measures that can give us an idea of the current state of market valuations.

The Ratio of Market Capitalization to GDP

In a Forbes interview, Warren Buffet described this ratio as “probably the best single measure of where valuations stand at any given moment.” It’s simply the total market capitalization of the stock market divided by GDP. The following chart shows how this measure has varied over the years and where it currently stands. Below that is a chart of the S&P 500.

Market Cap / GDP Ratio, Source: Vectorgrader.com

S&P 500, Source: Vectorgrader.com

As we can see, this ratio is the highest its been since around the year 2000. It suggests that market prices are rich relative to GDP at the current moment. Of course that doesn’t mean that stock prices are ready to crash, just that investors should be cautious.

John Hussman, a stock market analyst and fund manager (hussmanfunds.com) says that annual returns are driven by the following:

1. Growth in nominal GDP

2. The reversion in the ratio of market capitalization to GDP toward its historical norm

The historical norm of the market cap to GDP ratio has been about 0.63. In early 2000, it hit its highest level of 1.54. At that point, the dividend yield for the S&P 500 was 1.1%. If we assume a generous nominal GDP growth of 6.3%, Hussman says that an estimate of the subsequent 10 year annual return could have been calculated as follows: (1.063)(0.63/1.54)^(1/10) – 1.0 + .011 = -1.7% annually.This means pretty much negative to flat returns for a decade. Sure enough, the actual total return of the S&P from 2000-2010 was still negative even after bouncing back from the March 2009 lows.

Hussman then provides a valuation study for 2014. The current market cap to GDP ratio is 1.25, about double its historical norm of 0.63. If we assume nominal GDP gets back to a healthy growth rate of 6.3% and with an S&P dividend yield of 2%, we can estimate the following 10 year return to be:

(1.063)(0.63/1.25)^(1/10) – 1.0 + .02 = 1.3% annually

In other words, according to this, we can expect pretty anemic returns for the next decade at these levels. Off course, if the market sells off drastically, investors getting in at better levels can expect to achieve greater returns.

The chart below from John Hussman’s website is instructive. It shows projected 10-year return based on the formula above against the actual 10-year return that occurred. As we can see, the two lines correlate pretty well with each other, so the formula does a pretty good job of predicting what the return will be based on current market cap / GDP and dividend yield. Based on current stock market valuations, the chart and formula is predicting low single digit returns over the next 10 years.

Projected and Actual Returns for the S&P 500, Source: hussmanfunds.com

Corporate Profits to GDP

Another area where we see evidence that the U.S. market may be overvalued is company profits. The corporate profits to GDP ratio is at all time highs. Profit margins are cyclical and mean-reverting, so they’re not likely to remain at these levels forever, unless something fundamentally has changed and companies can expect permanently high profit margins.

Corporate Profits to GDP Ratio, Source: St. Louis Fed

The Current Market Is Still Not As Frothy as in 2000

Although valuations may be rich, we still aren’t seeing the same maniacal prices for tech stocks especially as exhibited in 2000. From a recent BBC article, Kathleen Smith of IPO investment advisory firm Renaissance Capital says there have been 53 listings of IPOs so far in 2014 which is half what we had for the same time period during 2000. Also, the price performance of newly-listed shares isn’t as extreme as in 2000. In 1999, more than 100 companies saw their share price double on the first day. In 2000 there were 80. So far this year, there have only been 4. (http://www.bbc.com/news/business-26739649)

It also seems like large-cap stocks are still reasonably priced. Based on data from the Bespoke Investment group from a New York Times article:

In 2000, the 10 biggest stocks in the S&P 500 had an average P/E ratio of 62.6. Today, that number is only 16.1.

I did a Google Trends search to see how often the term “Stock Bubble” was searched for and came up with the following chart:

“Stock Bubble” Search Interest, Source: Google Trends

After the peak in interest in middle 2007, the years 2008 and 2009 were some of the most turbulent market periods in history. For 2010, 2011, and 2012, we don’t see much interest in the term, until late 2013, where searches for “Stock Bubble” increased again. Not to say that this is predictive of a market crash in any way, it was just something I found interesting to note.

Conclusion

Overall, I think that investors need to be cognizant of the fact that the market is valued more richly than in the past few years, especially certain sectors such as internet and biotech. At least part of this recent bull market has been the result of easy money policies by the Fed. Interest rates are bound to increase at some point and that will put pressure on corporate profits and stock prices. This doesn’t mean you should dump your stocks however, especially if you have a long-term time horizon and a diversified portfolio. If you do, then a 30% or more market correction should not scare you and will actually be an opportunity to get in at better levels. If however, you are close to retirement, then considering moving a part of your portfolio into cash or safer assets may be a prudent strategy.